Why trade finance is an important form of funding and how recent policy changes can strengthen it

trade finance, trade receivables discounting system, credit insurance, trade credit, MSMEs

The last decade has witnessed considerable development in the trade finance sector, including complexities in transaction structures and the increased volume of transactions. This has become possible due to a number of legal changes, including new legislation. There is no doubt that trade finance is going to be an important form of resource raising for the foreseeable future – both for big corporates as well as micro, small and medium enterprises (MSME). This article focuses on two important changes related to trade finance that will be effective in 2021. The first is widening the scope of trade credit insurance, and second is the amendment to the Factoring Regulation Act, 2011 (Factoring Act).

Trade Credit Insurance

To put it simply, trade credit insurance protects the manufacturers, traders and service providers against the risk of non-payment for goods and services by buyers. Trade credit insurance generally covers the risk associated with insolvency of the buyer, protracted defaults by the buyer or certain geopolitical risks because of which the buyer is unable to make the payments.

As of date, a limited form of trade credit insurance is allowed in India. From a trade finance perspective, the current regulatory regime does not allow the benefits of trade credit insurance to banks, factors, financiers or lenders (financiers). Even if the trade receivables are assigned, the benefits of trade credit insurance cannot be passed to the financiers. This effectively means that the trade credit insurance can only be procured by the sellers when they are not intending to assign these trade receivables.

It is important to note that generally trade finance products are unsecured and non-availability of trade credit insurance means more risk for the Financiers. This leads to some amount of hesitation on their part in providing financial solutions to the sellers. This is even more so when the seller is a MSME as their risk profile is considered higher. Even on the government recognised TReDS platform this facility is not available.

The problem is amplified by the fact that all kinds of trade finance products do not qualify as ‘financial debt’ under the Insolvency and Bankruptcy Code, 2016 (IBC). The trade receivables if assigned without recourse will be classified as ‘operational debt’ under the IBC. Given that operational creditors rank lower than the financial creditors in a liquidation scenario, effectively, the Financiers bear the risk of getting nothing or very little from the liquidation proceeds.

In March 2020, IRDA allowed credit insurance for the TReDS platform and trade credit insurance for MSME sector under a regulatory sandbox approach.

In April 2021, IRDA issued draft guidelines on trade credit insurance. As per the draft guidelines, the credit insurance will cover the suppliers as well as banks and other financial institutions. It specifically includes that the cover will be available to factoring companies, banks and financial institutions. The credit insurance shall not be available for ‘reverse factoring’ and ‘financial guarantee’. This is understandable as reverse factoring and financial guarantees are financing transactions and may not be backed by receivables in the true sense.

The scope of credit insurance has also been broadened under the draft guidelines. Earlier, this was offered on a whole turnover basis only. Now, this may be offered to cover individual buyers in case of MSMEs. Single invoice cover will also be allowed on the TReDS platform.

The maximum indemnity for financiers has been kept at 60% of trade receivables from each buyer. The limit in other cases is up to 90% of the trade receivables from each buyer. While the reason for this difference is not clear, one may argue that financiers are more sophisticated clients and therefore in a better position to assess the risk.

The benefits of trade credit insurance which have been taken in case of cross border transactions will no doubt be possible for onshore transactions also. This is bound to provide much needed fillip to the sector and take trade finance transactions to a different level in the coming future.

Amendment to the Factoring Act

The Factoring Act was passed with an intention to address the problems of delay in payment and liquidity faced by all enterprises, including MSMEs. While the Factoring Act has reached a certain milestone, it is still far from seeing the success that it intended. Therefore, the Indian Government has decided to bring some important amendments through the Amendment Act. Some key changes/amendments worth noting are:

· As per the Factoring Act, a non-banking financial company (NBFC) can undertake factoring business if it satisfies the specified threshold of income and assets and is registered as a factor with RBI. This led to an ambiguity if other NBFC can provide factoring products or not. The Amendment Act removes this threshold of registration. Subject to RBI providing clarity, it seems that mostly all kinds of NBFCs will be able to provide factoring services.

· The definitions of ‘assignment’, ‘factoring business’ and ‘receivables’ have been amended to bring some clarity and align them to internationally recognized definitions.

· The concept of Trade Receivables Discounting System (TReDS) has been explicitly included in the Factoring Act. This was important from the perspective of the operation of the TReDS platform. It will therefore be possible for the TReDS platform to file the assignment details with the central registry on behalf of a factor.

· The time period for filing with the central registry has been removed and separate notifications will be issued in this regard. The intention of the legislature is to reduce the time period of filings in order to reduce double financing on the backing of the same receivables.

· RBI has been given wide powers to frame regulations in respect of (a) granting certificate of registration; (b) filing of particulars of transactions with the central registry on behalf of factors; and (c) any other matter which is required to be specified by regulation.

Both the aforesaid changes show a road map, but the actual picture would be clear once the guidelines are issued by IRDA and RBI. Expanding the scope of trade credit insurance and inclusion of all kinds of NBFCs to undertake factoring transactions would surely increase market participation and provide a boost to this much needed source of funding. The clarity about the operation of the TReDS platform would be beneficial for the financiers as well as the MSME sector.

This article is co-authored by Pratish Kumar and Anish Mashruwala, Partners at J. Sagar Associates.

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